Federal Reserve Reform And The Federal Reserve Independence Act

In the wake of the multibillion dollar losses at JP Morgan there have been increasing calls for Jamie Dimon to resign from the board of directors of the New York Federal Reserve (see this petition, for example).  We agree that he should resign.

But we also think that he shouldn’t have been there in the first place. His presence on the board is evidence of a broader problem with conflicts of interest in the governance of the Federal Reserve, particularly the regional banks. The regional banks are important public regulatory institutions and they should not be managed by the  financial institutions they are charged  with regulating.

The Board of Governors of the Federal Reserve is chosen by the President and subject to Senate confirmation. But two-thirds of the directors in each of the 12 regional banks that make up the Federal Reserve system are elected by the local banks in that region. These directors may hold stock in or invest in regulated banks. Up to one-third of the board of directors for each regional bank (so-called ‘Class A Directors’) may also be current employees of the regulated banks in that region. And typically they are.

The financial crisis and its aftermath have made clearer than ever before the central role the Federal Reserve plays in our financial system. During the crisis of 2008 and 2009 the Federal Reserve granted trillions of dollars of direct lending assistance to individual banks through special credit programs. The Fed’s role in setting interest rates through the Open Market Committee is enormously important in good times and bad – and regional directors elect the regional bank presidents on that committee. But the Fed’s role in the everyday supervision and oversight of banks and bank holding companies also influences the allocation of trillions of dollars in our economy.   Much of this supervision is actually performed by  the regional banks, which means the boards for these regional banks are in a position to impact  it. This issue is particularly acute at the New York Federal Reserve, which supervises the largest Wall Street banks. We now know, for example, that lenient supervision at the New York Federal Reserve played  a crucial role in the massive risk management failures at Citibank that helped lead directly to the crisis.

In the fight over the Dodd Frank act AFR advocated changes to increase the Federal Reserve Board’s accountability to the public, and remove the undue influence of Wall Street banks. But in the end the Dodd-Frank Act made only very limited changes in this area. The law mandated that Class A directors could not participate in the selection of the bank president. In addition, the Federal Reserve Bank of New York has changed its bylaws to limit the role of Class A directors in oversight of bank supervision.  More dramatic change is needed.

New legislation introduced by Senators Sanders, Boxer, and Begich — the Federal Reserve Independence Act — would make that change. Their proposal would not only require the removal of Jamie Dimon from the New York Fed, but would fix the structural problem that put him there in the first place. The bill mandates that the directors of regional Federal Reserve banks be appointed by the democratically selected Board of Governors, rather than elected by the banks they supervise. It also bans directors or employees of the Federal Reserve from holding stock in the banks they supervise. These are straightforward, common-sense solutions to the conflict of interest problem that should become law.

JP Morgan And The Volcker Rule: It’s Not About Banning Risk

Opponents of new financial regulations are starting to claim that JP Morgan losses don’t show us much about the need for new restrictions on bank activities. First, they say, risk is inherent in banking, and no restriction can eliminate it. Second, there’s no benefit in restricting the types of risks that are taken — traditional lending risk permitted under the Volcker Rule is the core problem in financial oversight. An anonymous banker summarized the argument in a statement to Politico’s “Morning Money” last week:

“The inconvenient truth is that ‘plain vanilla’ lending is far and away the riskiest activity any financial institution can engage in. Virtually every financial crisis in history – including the most recent one – was caused principally by lending-related losses. The value of mortgage-backed securities plummeted in 2008 not because those securities were traded, but because too many of the mortgages… backing those securities were poorly underwritten … The notion that we can legislate or regulate risk out of banks is absurd.”

First, the banker is dead wrong about the relationship between trading risk and the 2008 crisis.  The loans packaged into mortgage-backed securities were indeed poorly underwritten. (One reason is exactly that the loans were sold off into traded securities –underwriting practices can become lax if the lender does not plan to keep the loan). But the losses from those loans, while severe, would not by themselves have created the financial crisis we saw in 2008. As Ben Bernanke stated in a recent speech, aggregate subprime loan losses amounted to several hundred billion dollars, not in itself enough to take down the global economy.  Problems in the mortgage market triggered the collapse because of a vast structure of financial market trades based indirectly on the value of those mortgages. That structure included trillions of dollars in synthetic derivatives bets (synthetic CDOs), as well as trillions of dollars in short-term (overnight) funding tied directly to traded valuations. That was the structure that collapsed and took the economy down with it.

Second, no one is trying to – or could – ban risk from banking. The goal of the Volcker Rule is instead to change the form and location of risk. The rule moves one particular type of risk –proprietary speculation in the financial market ‘casino’ – out of the giant banks at the center of the economy and into smaller hedge funds and other speculators who can fail without threatening the system.  The Volcker Rule permits banks to continue risk taking in the form of lending and investment, as well as low risk forms of market making.

That’s because risks created by financial market gambling differ in important ways from those created by long term investment and lending. Financial markets are inherently unstable and volatile, vulnerable to bubbles and crashes. At the extreme, markets can fail completely during periods of panic and trading can become impossible. When institutions central to the economy are gambling their money in these markets, the entire system becomes more vulnerable. Supervisors can require banks to reserve capital against this risk, but today’s speculative instruments can create enormous financial exposures that are very difficult to predict. Determining those exposures relies on complex and uncertain mathematical models that have a history of spectacular failures (and just failed JP at Morgan yet again).

That’s the risk part of the problem. There’s also the connection to the real economy to think about. Speculating in secondary trading markets occurs at several layers of remove from real economy capital provision. Much of the volume in today’s financial markets is just derivatives bets on future prices, with no actual lending or investment involved. There are some risk management benefits for hedgers. But the real economy benefits of, for example, the exotic credit derivatives JP Morgan was speculating in appear limited at best. And paper speculation can actually suck money away from the real economy.

In contrast to financial market speculation, lending and long-term investment have a direct real economy connection and the risks are easier to understand. Exposures are more straightforward and underwriting is less dependent on complex mathematical assumptions and more on assessing basic creditworthiness. In addition, when lending goes wrong the banker often has time to ride out the problem and restructure the debt. Speculative market exposure forces loss recognition immediately and makes banks vulnerable to contagious market panic.

So the Volcker Rule builds a firewall between speculative trading and basic credit intermediation. Banks can take risks in traditional, longer-term lending and investment, but their financial market activities should be limited to low-risk market making and hedging. Banks are resisting this shift, since their business models have mixed market trading and basic banking functions in so many ways. But it’s strange that anyone should find the basic idea outrageous, since it’s the same distinction made in one of the most famous and long-lasting regulations in American history, namely the Glass-Steagall division between depository and investment banking.

Cost Benefit Analysis and Financial Reform

There are three fronts in the battle over financial regulation — Congress, the regulators, and the courts. The third gets perhaps the least attention, but legal challenges to new regulations are a major issue that could undermine the entire process of implementing the Dodd-Frank Act. The DC Circuit Court has already overturned SEC proxy access rules on cost-benefit grounds in the ‘Business Roundtable’ decision. Lawsuits have also been filed against rules for commodity market speculation limits and derivatives oversight rules, and future suits are threatened against a wide range of major rules. This legal threat is creating a serious chilling effect on regulators’ implementation of new Dodd-Frank rules.

The challenges are all grounded in judicial review of agency rules on the basis of cost-benefit analysis. While controversial, such cost-benefit analysis has long been a fixture in other areas of regulation such as safety and health. But the scope of the challenge to Dodd-Frank on cost-benefit grounds is something new in the area of financial regulation. Americans for Financial Reform recently held a half-day conference to examine both the legal and economic aspects of applying cost-benefit analysis to financial regulations.  Some of the presentations included a keynote address by CFTC Commissioner Bart Chilton, an overview of the scope and nature of cost-benefit challenges by Dennis Kelleher of Better Markets, a critical analysis of the DC Circuit’s recent Business Roundtable decision by Jay Brown of the University of Denver Law School, a presentation by AFR Policy Director Dr. Marcus Stanley on the issues raised by applying formal cost-benefit analysis to financial regulation, and more. See all the presentations here.

The JP Morgan Debacle: Synthetic ‘Hedges’, Real Banking, and the Dodd-Frank Act

JP Morgan CEO Jamie Dimon has been a leading voice in the call to roll back the Volcker Rule and other provisions of the Dodd-Frank Act. His anti-regulatory message just lost a lot of credibility.

So far, the unforseen losses on JP Morgan’s London trades are around $2 billion (although more may be coming). That’s a level that the bank can probably absorb. But this story is so compelling because it highlights two deep problems in our banking and regulatory system. The first is the capture of the banking system by a culture of speculation that fails to serve the real economy. The second is the willingness of regulators – and bank risk managers themselves — to believe claims that this speculation is low risk or ‘hedged’ when in fact it poses great risks. The Dodd Frank Act includes tools to take on these problems, but regulators have to get tough and truly use those tools in order for them to work.  And Congress has to resist Wall Street pressure to roll them back.

We don’t know exactly what JP Morgan’s trade was. But from their statements and what the press has found, JP Morgan appears to have hedged securities holdings with an arbitrage trade on a credit default swap index. The transaction would work like this:

1)      Cash holdings from bank deposits were invested in what the bank calls ‘very high grade securities’. The highest grade securities would be some form of US Treasuries.

2)      These securities were then hedged by buying credit protection on an index of investment-grade securities. Such protection could theoretically reduce risk, but it costs money.

3)      The costs of buying credit protection were then offset by selling protection on another closely correlated credit default swap index – most likely a different maturity point of the same index.

This last step was probably sold as making the initial ‘hedge’ more efficient – but in fact it converts that ‘hedge’ into a speculative arbitrage or spread trade. If the spread between the instruments JP Morgan bought and sold is positive, then the bank makes a profit and increases the return on its securities. Even if the spread is low or zero, the trade can still be portrayed to regulators or risk managers as a hedge. The problem comes when the speculative trade goes sharply negative. Mathematical models say this risk is low for correlated trades, but these models have been proven wrong over and over again, going back to Long Term Capital Management in the 1990s.

Even before questions of risk and regulation, the first issue is just how far removed from traditional banking and the real economy this is. Rather lending deposits to businesses, JP Morgan placed the assets in low-return Treasury bills or perhaps blue chip corporates (the same large corporations who are currently sitting on over $2 trillion in cash). At current interest rates, the return on such instruments is very low. So the bank sought out higher returns. But instead of trying to raise returns by seeking out real economy lending opportunities, JP Morgan instead tried to increase its return by trading derivatives on synthetic credit default swap indexes – pure paper speculation.

To make things worse, because it was hoodwinked by its own mathematical models (JP Morgan now admits its VAR model was ‘inadequate’) the bank apparently did not even understand that this speculation involved risks at least as great as it would have incurred had it made real economy investments.

The replacement of real banking by purely speculative, synthetic banking is at the heart of the problems with our bloated and inefficient financial system. The Dodd-Frank Act contains multiple tools designed to address this problem. The foremost among these is the Volcker Rule, which is designed to get banks out of the business of financial market speculation and back into supporting the real economy. But many other sections of the Act address the problem too. These include the ‘swaps push out’ provision that would separate derivatives trading from core banking functions, new rules on derivatives that increase the collateral and margin that must be set aside against speculative trades, and even new prudential capital requirements that should force better recognition of speculative trading risks.

But the effectiveness of these rules depends on how regulators implement them – and unless regulators change their lenient attitude toward the culture of Wall Street trading, that implementation will not be effective. The clearest example is the definition of ‘hedging’. Most Dodd-Frank rules have exceptions of some sort for hedging operations that are truly risk reducing. This is true for the Volcker Rule and for many of the derivatives rules, including the swaps push out provision. The problem is that in the culture of speculative trading, hedging does not simply mean risk reduction. It means something closer to ‘a trade that will reduce my risks if markets behave as I expect, while giving me the chance to increase my profits’. Basic economic theory says that you cannot reduce risks without sacrificing opportunities for higher returns. Hedge trades should lower risks, not increase profits, and ‘hedging’ operations – such as JP Morgan’s Chief Investment Office – should never be profit centers. In fact, it clearly was a profit center (until it became a loss center) and not in the hedging business.

The implementation of the hedge exemption in the Volcker Rule does not take this principle into account. It also allows vague and ill-defined ‘portfolio hedging’ that would be a perfect refuge for these types of arbitrage trades, along with dynamic rebalancing of hedges that is necessary for sophisticated arbitrage. To make things worse, the rule would not scrutinize trading positions held longer than two months. Many spread trades are held for relatively long periods. Indeed, as the AFR Volcker Rule comment letter argues, the combination of a broad hedge exemption and little scrutiny of long-term positions makes the current Volcker Rule proposal extremely vulnerable to arbitrage trading.

The Volcker Rule is not the only area where this episode reveals vulnerabilities. For example, in its implementation of new capital rules the Federal Reserve appears to have accepted the inadequate base levels of capital required in the new Basel III accord. It will apparently rely on model-based ‘stress testing’ to determine when additional capital is needed. Yet these stress tests rely on the same type of VAR model that failed in this case. Other areas of derivatives regulation, such as the ‘swaps push out’ requirement and dealer oversight have hedge exemptions that raise similar issues to those in the Volcker Rule. And basic derivatives protections like clearing and margining that would help make these types of trades safer are under attack in Congress – as well as by industry lobbyists putting pressure on regulators.

Regulators and Congress need to learn from this episode. We need to put tough restrictions in place to reorient banks on serving the real economy, and we can’t rely on Wall Street assurances that their speculative trading is safe.  Strong versions of already enacted Dodd-Frank laws are a necessity, but Congress also needs to seriously consider measures to break up the big banks, such as Senator Brown’s SAFE Act.